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Case Study 2

1656 words - 7 pages

Assume an immediate and sustained one percent across-the-board rise in interest rates. Based on a review of Exhibit 3, discuss how one would use interest rate sensitivity gap information to estimate the impact of rising interest rates on the earnings of Norwest Corporation.
If the interest rates are anticipated to increase by 1 percent then to reduce the impact on earnings the corporation must keep a Positive Gap. This means that the rate sensitive assets should be more than the rate sensitive liabilities. If this is positive then the increase in interest rates increases the net interest income. The Gap of the corporation is mostly positive for all the time periods except for the ...view middle of the document...

Generally, the former is measured using the TGA (Traditional gap analysis) and the latter is measured using more sophisticated DGA. Banks should carry out both the analyses.
Spread Risk (reinvestment rate risk)
Changes in interest rates will change the bank’s cost of funds as well as the return on their invested assets. They may change by different amounts.
If interest rates change, the bank will have to reinvest the cash flows from assets or refinance rolled-over liabilities at a different interest rate in the future.
An increase in rates, ceteris paribus, increases a bank’s interest income but also increases the bank’s interest expense.
Static GAP Analysis considers the impact of changing rates on the bank’s net interest income.

Price Risk
Changes in interest rates may change the market values of the bank’s assets and liabilities by different amounts.
If interest rates change, the market values of assets and liabilities also change.
The longer is duration, the larger is the change in value for a given change in interest rates.
Duration GAP considers the impact of changing rates on the market value of equity. Norwest uses a simulation model to determine earnings risk whereas measurement of economic perspective is done through a market valuation model. The cash flows are discounted by a market interest rate chosen to reflect as closely as possible the characteristics of a asset or liability

What would you suppose to be some practical difficulties in art of earnings simulation modeling? Why is it preferred method for measuring interest rate risk?
Practical Difficulties:
A simulation can misrepresent the bank’s current risk position because it relies on management’s assumptions about the bank’s future business. The myriad of assumptions that underlie most simulation models can make it difficult to determine how much a variable contributes to changes in the value of the target account.
For this reason, many banks supplement their earnings simulation measures by isolating the risk inherent in the existing balance sheet using gap reports or measurements of risk to the economic value of equity.
In measuring their earnings at risk, many bankers limit the evaluation of their risk exposures to the following two years because interest rate and business assumptions that project further are considered unreliable. As a result, banks that use simulation models with horizons of only one or two years do not fully capture their long-term exposure.
A bank that uses a simulation model to measure the risk solely to near-term earnings should supplement its model with gap reports or economic value of equity models that measure the amount of long-term reprising exposures.
Preference over Gap Methods:
It Allows management to incorporate the impact of different spreads between asset yields and liability interest costs when rates change by different amounts.
Simulation models allow some of the assumptions underlying gap reports to be amended. For...

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